EU Policy Continues to Lead Markets

NEW YORK (BBH FX Strategy) - European markets turned defensive this morning after a rally in Asia amid signs of ongoing divisions in Europe. Eurozone policy makers have made some progress on the way to a comprehensive crisis plan for Europe but there are still a lot of open questions ahead of Wednesday's second summit, where officials have pledged to present a final solution.

As a result, European stocks have given up most of their early session gains and the dollar made up ground after the EUR, GBP and dollar bloc currencies failed to break through multi-week highs. EZ manufacturing purchasing managers' index remained soft, highlighting growth risks ahead. In Asia, the market took encouragement from a rebound in China flash manufacturing PMI, while Japanese exports also improved as Japan move back into surplus.

In the week ahead, markets are keen to focus on two of the key market forces currently driving foreign exchange markets, including stabilizing macro data and the eurozone policy response to the sovereign debt crisis. Indeed, this week's EU Summit is expected to deliver the final decisions on the strategy that marks the end of the sovereign debt crisis.

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After the latest meeting this weekend it has become clear that policy makers are expected to move on a three-prong approach that involves 1) bank recaps 2) greater private sector involvement in the Greek bailout 3) leverage scheme for the European Financial Stability Facility, which is likely to be on the German insurance model. While more clarity on details are likely to emerge this week, the scope for disappointment remains high. The key issue will remain whether leveraging the EFSF by providing first-loss guarantee would be seen as a credible liquidity backstop for the likes of Italy and Spain.

On this front we continue to expect that over the medium the potential policy response this week is unlikely to achieve this without significant European Central Bank support, along with a strategy focused on economic growth. Nevertheless, in the short-term we still see scope for marginal support for the euro off the back of the extreme short positions in both risk and the euro against the dollar. Recent CFTC speculative positioning continues to the show market remains long dollar against nearly all reported currencies.

On the data front, we get German consumer confidence and CPI data, along with third quarter GDP from the U.S. Italy, which will be important to watch due to the recent run up in bond yields, publishes consumer confidence as well and retail sales. In addition, Italy will try to issue 5 to 6 billion euros in bonds on Thursday and Friday, possibly the first real test of market confidence after this week's summit.

Beyond this there are a host of central bank meetings this week in Sweden, New Zealand and Canada, although all of these banks are expected to remain on hold. The Bank of Canada in particular is likely to be supportive of CAD, given our expectations the bank will reaffirm its Q3 growth outlook.

This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.

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